How will policymakers remember 2020?

The spike in inflation could have a lasting impact on macro-policy.

Much as economists, central bankers and policymakers might not like to admit it; stories matter in macroeconomics. Policy is rarely, if ever, set in a vacuum. Economic policy is instead formed in a political context and politics runs on narratives.

The 1970s, and specific interpretations of exactly what went wrong, loomed large over the policymaking of subsequent decades. Just as the 1930s, and a particular story of exactly what happened, set the tone for much of the 1940s to 1970s.

The story of economic policymaking in 2020-21, amongst both the global policy elite and the general public, seems to be shifting. That shift matters because the accepted story of 2020-21 will shape how policy acts in the years to come.

As recently as eight or nine months ago, the story of 2020-21 in the advanced economies, went something like this:

The covid-19 pandemic – and the associated lockdowns and disruption – caused an unprecedented collapse in economic activity. Policy responded quickly and aggressively. Central banks cut rates and expanded (or in some cases launched for the first time) programmes of quantitative easing. Fiscal policy was very loose. The European states protected jobs via furlough and short-time working schemes while America protected incomes via vastly enhanced payments to households. Firms received cheap government-backed loans.

The result was that, despite a steep initial drop in GDP, household incomes were protected and business failures remained low. Governments absorbed an unusually large share of the cost of recession via an increase in public debt – but low interest rates meant that, in most cases, the annual servicing costs of debt actually fell.

This was, rightly, widely seen as a spectacular public policy success story. And one that prompted a wider debate on economic policy itself - both in terms of its tools and of its effectiveness.

Some, of course, argued that the lessons of 2020 could not be generalised – that the pandemic was special case. Recessions aren’t generally the result of the government ordering people to stay at home and firms to close down. Others believed that the fiscal-monetary policy co-operation of 2020 offered wider lessons in how to manage the business cycle more generally. At the very least, the effectiveness of fiscal and monetary policy in 2020-21 seemed to offer solid grounds for relitigating the experience of 2010-11 in which policy support was, generally, withdrawn abruptly.

A briefing in the Economist in the summer of 2020, coupled with a provocative cover, caught the mood.

Whilst the future was unclear, a larger and more active role for the state seemed almost a given.

All these new ideas will now compete for space in a political environment in which change suddenly seems much more possible. Who could have imagined, just six months ago, that tens of millions of workers across Europe would have their wages paid for by government-funded furlough schemes, or that seven in ten American job-losers in the recession would earn more from unemployment-insurance payments than they had done on the job? Owing to mass bail-outs, “the role of the state in the economy will probably loom considerably larger,” says the BIS.

Adam Tooze’s Shutdown was published a year later. It’s an excellent book (which I reviewed last year for Prospect) and was the first in-depth instant history of the period. It not only documents just how unusual the policy stance adopted in 2020 was, but also retains a solid dose of scepticism about how lasting the impact would be. As I noted in my own review:

It would be easy to look at the fiscal/monetary mix in 2020 and conclude, as Tooze puts it, that there was “a powerful synthesis of fiscal and monetary policy working in harmonious co-ordination to help fund a generous new social contract,” whether that new social contract took the form of much higher unemployment insurance, as in America, or the furlough scheme in Britain. But, as he argues, this is far too rose-tinted… the sea change in monetary/fiscal policy co-operation remains incomplete, confused and contested.

That scepticism was justified.

Whether the current bout of inflation proves temporary or sustained, it is already changing the conventional wisdom.

The story of ‘aggressive fiscal and monetary policy prevented a depression’ is morphing into ‘aggressive fiscal and monetary policy lead to the highest inflation in three decades’.

For what’s worth, I don’t think that interpretation is at all fair. The counterfactual world in which policy had not responded as it did would be grim. Inflation might well be materially lower but unemployment would be a much more pressing problem, business failures would have soared and, in the face of mounting economic costs, many countries would no doubt have dropped social distancing well before the vaccines arrived leading to more deaths.

But stories do not have to be either fair or true to have power. A year ago I assumed that whenever the next recession came along that, guided by the lessons of 2020, the policy response would be more aggressive. Now I am not so sure at all.

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